How to Trade the VIX

By: Michael Khouw

The VIX can't be traded directly, but Michael Khouw
explains how traders can trade a security based on the VIX.

My guest today is Michael Khouw, and we're talking about the VIX and
most traders, newer traders, think you could probably trade the VIX outright but
that's not necessarily the case. Michael's going to talk about how you can
actually trade somewhat similar to the VIX. Mike, how do you trade the VIX
in essence? I know you can't trade the instrument itself, but what are you
supposed to do?

Well you know I think a lot of people make the mistake of they look at the
news, they hear people talk about VIX, and they assume that's a tradable
instrument, and sometimes the way people talk about it makes it sound as if it
is. The VIX is 15. I would like to buy the VIX at 15, that kind of
thing.

But actually the VIX that everybody talks about is something we call spot
VIX. It's really just a calculation. It's based on an interpolated
strip of options prices in the S&P. One way to think about it, though,
is it is the implied volatility or the relative premium, you might think of it,
for a 30 delta 30 day put in the S&P.

So, if you're ever trying to say, okay, well what does that represent?
It's the implied volatility of a 30 day 30 delta put is probably the one option
that comes closes to it. There are other ways to trade it, of
course. You could trade VIX futures. You could trade options on
those futures. I don't typically recommend that for hedging purposes,
though, because there are a lot of dynamics in there that people don't
recognize.

For example, the VIX futures curve is upwards. Sloping is something
called Contango, which means you have to pay an ever higher price every single
time, so if you roll your futures, you always have to pay that spread.
There's another thing, too, which is if you buy long-dated futures or options on
longer-dated futures, those futures tend not to move as much as the spot VIX
does, so when you see the VIX spike to 45, and you own a six month VIX future,
and you say how come one went up 30 points and mine only went up 5 points.
Why is that?

Well, that has to do with the dynamics of what VIX really represents, 30 day
forward starting variance. We don't need to get into the math of what that
means, but trust me. Probably the best way to think about hedging is to
stay away from the VIX for most people.

Alright. Now another generality I hear a lot from traders is
when the VIX is low, I'm a buyer of calls and puts. When the VIX is high,
I'm a seller. Is that necessarily true as well?

No, it isn't necessarily true, although it can be one way to think about
things, right? So, when the VIX is exceptionally high there are a couple
things about the market place that are often true. For one thing, it
usually happens after the market has dropped precipitously. Probably
everybody recognizes that. The initiation of the credit crisis-what
happened to the spot VIX calculation? It went through the roof. What
had happened to equity prices? They had declined significantly.

Here's one way to think about that. Do you go out and start buying
insurance after the house is already on fire? Probably not a really good
idea. One, it's expensive, and two, what they're insuring isn't worth
much. The same thing is true here. You don't want to race out and
start buying protection in the S&P when the VIX is high, and that I think is
the more important point than saying maybe we would buy it when it is low.

What we're saying is that you can't buy it all the time. You're better
off buying it when it's low, but like insurance of any kind, you buy it
expecting it not to pay off. Always owning options tends to put a drag on
people's performance. It tends to put a drag on your portfolio. You
can't expect to pay insurance all the time and hope to win. It's a little
bit like buying lottery tickets all the time and hoping that you're going to
come out ahead in the long run. You won't.